Analysis of developments in financial markets, economics and public policy geared towards anyone with a stake in these issues......and, yes, we all have one.

Wednesday, February 27, 2013

Commodities Part II: Still a Worthy Investment?

In last week’s posting, several still-intact
factors of what has been called the commodities super-cycle were highlighted.
Chief among them were not only continued urbanization and infrastructure
spending in Asia, but also potential supply constraints of key industrial
inputs in the metals and energy space (North American natural gas and shale oil
not withstanding….although the possibility remains that overzealous regulators
could shoot that gift horse right between the eyes). Regardless of fundamental
strength, it is an entirely different question whether or not commodities can
still be considered attractive investments. In order to answer this we must
first recognize what has drawn investors to commodities in the first place.

A Brief History of the World….Well At Least of Financial Markets over
the Past Decade

Easy enough. As an asset class,
commodities have historically shown little correlation with the dominant
buckets in investment portfolios, namely equities and bonds. Over time, such a
characteristic should have a smoothing effect on portfolio performance.
Commodities also tend to be positively correlated with inflation, whereas other
asset classes suffer in periods of rising prices. This makes sense as inflation
diminishes the value of future cash flows from bond coupons and stock
dividends. It also squeezes the profit margins of corporations hesitant to pass
rising input costs onto consumers. Such rising industrial inputs are often
commodities and thus direct exposure to them would logically lead to positive returns. And
speaking of returns, during the earlier part of the past decade, investors
clamored for commodities exposure not only for diversification and inflation
hedging, but also for the juicy yields the asset class offered in its own
right. This was driven not only by the aforementioned fundamentals, but also by
favorable investment conditions thanks to the Fed’s….ahem….low interest rates
of 1%, which provided plenty of kindling for a range of asset bubbles.

As with other investment management
tenets, many of commodities’ attractions were turned on their head during and
after the financial crisis. The chart above illustrates the crisis axiom that the only thing that goes up during
recessions is correlations. Commodities, equities and other putatively
risky assets all sold off in unison as investors clamored for cash. Even
safe-haven precious metals were temporarily hit as investors were forced to
sell what they could, not necessarily what they wanted to. While the yellow
metal has bounced back….climbing over 100% since late 2008…many other segments,
namely those associated with industrial inputs, have come nowhere near their
pre-crisis peaks. Much of this can be attributed to the lack of demand brought
about by the global recession, despite Chinese efforts to buy up nearly every
natural resource upon which they could get their hands. With the nadir of the
crisis four years behind us, investors must ask how the argument in favor of
commodities has changed.

Zigging and Zagging

Prior to the go-go 2000’s,
institutional money managers may have considered allocating a sliver of their
portfolios to commodities with the expectation that the inclusion of an asset
class not correlated with stocks and bonds would smooth out overall
performance. As seen in the table below, for the 16 years preceding the
financial crisis, commodities had a slight negative correlation to each of
these other asset classes. If stocks
and/or bonds fell, there was a chance commodities would stay flat or even rise,
thus offsetting losses in other buckets of the portfolio.

As stated earlier, during a market
panic, correlations among risky assets go to 1, meaning they all sink together,
and this is indeed what occurred in late 2008. Since then skittish investors
have chucked market fundamentals out the window and have instead hung on every
macroeconomic utterance emanating from the boardrooms of global central banks. The
result is a risk-on / risk-off trading environment where investors view nearly
all risky assets as homogeneous. Aggravating the situation is extraordinarily
loose monetary policy, which is forcing investors to indiscriminately pile into
assets further out along the risk spectrum. The end result is that by creating
a binary universe of risky and non-risky assets, the benefits of diversifying a
portfolio with commodities may be diminished. Despite possibly bullish
fundamentals in particular commodities (or equities) segments, should authorities
tap the brakes on generous monetary policy, there is the real possibility
investors will once again flee all risky assets for safe havens such as cash or
gold.

Inflation Hesitation

Not much makes an investor quake in
his or her boots more than the specter of rising prices diminishing the real
returns on their future cash flows. In advanced economies, inflation
usually rears its head as a consequence of economic expansion as aggregate
demand increases and employees with rising paychecks are more willing to put up
with higher prices at Safeway, the mall or Bucky’s Gun Nirvana. Such a
development is often welcome to equities investors who expect corporations will
have an easier time raising prices during these periods. If, however, expenses
rise to such a degree that firms cannot pass through the costs to customers
without triggering demand destruction,
equities may suffer. One source of higher input costs is raw materials, so
commodities exposure may yield positive returns at the expense of corporate
margins and consequently share prices. While there is a gray area with equities
regarding inflation, the attitude of bond investors is black & white: they
hate it.

Referring once again to the table
above, commodities have tended to be positively correlated to inflation,
providing investors with a natural hedge for the more vulnerable parts of their
portfolios. If one expects inflation to rear its ugly head, then dialing up the
commodities allocation makes sense. Presently, there is little hint of
inflation in advance economies. As seen below core CPI…excluding volatile and
supposedly ephemeral food and energy components…is presently sitting at 1.9% in
the United States, well below the Fed’s recently loosened target of 2.5%. Both
it and the headline number have trended down over the past year. Additionally,
in service-based economies like the United States, a chief contributor to
upward price pressure is rising wages, and that is highly doubtful with
unemployment stuck at 7.9%.

Despite the current benign
environment, naysayers will have you believe that loose monetary policy will lead
to asset-bubble driven inflationary pressure and that the Fed is notorious for
being behind the curve in raising rates to combat higher prices. One way to
gauge investors’ inflation expectations is to look at the inflation-protected
Treasury market known as TIPS, most notably the implied inflation rate for
periods farther out in the future. The chart below does just that, mapping out
not only the average inflation rate priced into TIPS over a five-year and ten-year window, but also the average rate implied between the years 2018-2023,
long after… supposedly…..the Fed has exited its current array of dovish
programs. Since the advent of QE3 last autumn, this figure has stood just below
3%. Not Weimar Republic or Argentina territory, but well above the Fed’s normal-times
acceptable range of 1.7% to 2%.

The Dollar's Role

One way in which low interest rates
prime the pump for inflationary pressure is through a weakening of the dollar. As
explained last week, a diminished greenback makes USD-denominated industrial
inputs cheaper for countries whose currencies are not linked to the dollar (and
yes this means commodities addict China is shooting itself in the foot with its
soft peg to the USD). Cheaper prices means higher demand, which will conversely
send up prices in USD-terms. This could lead to imported inflation, especially
via energy products. As seen below, over the past four years there have been
several bouts of extreme inverse relationships between the USD and commodities
as measured by the broad S&P GSCI index.

All of these inflationary scenarios
bode well for maintaining exposure to commodities, especially if robust
demand….belatedly….returns to advanced economies. Should the Fed be prudential
in rolling back current policy, a measured sell-off in frothy bonds may be
partially offset by a commodities allocation.But if authorities are behind the curve and inflation rises to
levels that trigger demand destruction across the economy, or if investors fear
the vagaries of the market without the guiding hand of Helicopter Ben and his
perpetual liquidity machine…invented centuries ago by Herr Guttenberg…then the
exit from risky assets could get ugly. In these situations, commodities
exposure would doubtfully deliver the promised hedging benefits.

A Welcome Development

The last decade’s surge in emerging
market demand along with epic-growth in the materials intensive U.S. housing
sector triggered investors to turn to commodities for yet another reason:
attractive returns. Hedge funds and institutional investors were the first to
rush through the doors to capitalize on the supply/demand imbalances. Further
liquidity was added through vehicles such as commodities ETFs that allowed
retail investors to gain exposure to the asset class. These developments have
proven to be a double-edged sword. Additional liquidity always greases the wheels
of price discovery, but the acceptance of commodities as a viable slice of
portfolios creates the possibility that its lack of correlation with other asset
classes may be diminished during market sell-offs (the aforementioned risk-off
trade).

And sell off did they ever. As seen
above, commodities have underperformed just about all other major asset classes
during the past five years. Slower global growth, especially in the U.S. and EU
are chief culprits. Segment-specific factors
have also shifted the balance back towards sufficient supply. Technological
advances in drilling have unlocked North American natural gas, with
expectations that shale oil may follow the same path.

Commodities returns are also
influenced by the term structure of the futures contracts upon which many
investment vehicles and strategies are based. In order to maintain long
exposure, investors must factor in not only price movements of contracts, but
also financing costs (currently negligible….a gift from the Fed) and the cost
of periodically rolling over those contracts upon expiry and reinvesting them.
As seen below, in periods of sufficient supply or weak demand the result is a cash
outflow to maintain exposure. In more favorable trading environments, investors
can earn positive returns when rolling these contracts. It all depends upon the
fundamental dynamics at play in each bucket within the commodities space.

Is the Party Over? Not Likely

Commodities, unlike other asset
classes don’t churn out periodic cash flows in the form of dividends or coupons.
Instead of relying on DCF models to ascertain fair value, investors must gauge
macroeconomic factors (growth, inflation and FX movements), underlying demand,
physical inventory levels and even the vagaries of weather and trade
disruptions in the form of labor disputes or conflict in sensitive regions. Taking
all of these moving targets into account is an inexact science to say the
least. Shifting also are the performance attributes of commodities within a
diversified portfolio. Will they offset stock or bond losses? Does the tame
near-term inflation outlook render exposure unnecessary? Will returns ever near
the last decade’s pace? The answers are likely both yes and no. How? Going
forward, savvy investors must analyze the space on a more granular level,
gauging the attractiveness of energy, metals and agricultural products on their
own merits. Such a return to
fundamentals…and sanity…will mean that investors can continue to
judiciously use segments of the commodities space to smooth out returns, and
perhaps even goose them, in both stable price and inflationary environments in
the years to come.

No comments:

Subscribe To

Blog Archive

About Me

During my career as an investment analyst, several developments from the realms of financial markets, economics and public policy struck me as highly relevant, not to me in my role as a market observer, but in my role as a citizen. The subjects covered on these pages are not aimed at fellow investors or policy junkies, but to the broader population, which needs to recognize the shifts occuring in the economy and understand their consequences, as well as those of government policy.